Following several years of low growth Germany is presently enjoying a relatively strong recovery. With unemployment falling at record speed and fiscal consolidation progressing, the upswing is set to continue in spite of uncertainties surrounding the VAT increase of January 2007. This Country Focus analyses whether the strong outlook merely signifies a cyclical recovery or whether it heralds a return to higher potential growth from the estimated level of slightly above 1% in the first half of this decade. In recent years three developments have taken place that may have helped lift potential growth. These include, first, the restoration of external cost competitiveness by means of wage moderation; second, the lightening of the reunification burden, notably by cutting the bloated construction sector down to size; and, third, a number of reforms, especially in the labour market. On the other hand, the lengthy slowdown has taken its toll in terms of reduced capital stock and persistent structural unemployment. This weakness in providing labour and capital inputs means that Germany risks losing some of its still strong capacity to innovate, and potential growth is likely to remain subdued. Implementing a coordinated reform agenda, however, would lift potential growth substantially.

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